Options for the Stock Investor: How to Use Options to Enhance and Protect Returns (PROFESSIONAL FINANCE & INVESTM) - Softcover

Bittman, James B.

Softcover

ISBN 10: 0071443045 ISBN 13: 9780071443043

Publisher: McGraw Hill, 2005

Synopsis

McGraw-Hill’s classic options bestseller, Options for the Stock Investor, has been updated to reflect changes in the options market. This extensively revised second edition features all-new material describing electronic trading, decimalization, and single stock futures, along with increasingly popular vehicles such as stock indexes, LEAPs, and exchangetraded funds.

About this title

About the Author

McGraw-Hill authors represent the leading experts in their fields and are dedicated to improving the lives, careers, and interests of readers worldwide

From the Back Cover

[BACK COVER][CATEGORY] Investing[CORNER CUT/READING LINE] Includes powerful Op-Eval4™ option analysis software [HEAD] Praise for the 1st Edition:

“The thoroughness of the coverage makes this exceptionally valuable reading for the … investor who’d like to add some sophistication in establishing and managing his stock holdings by using options.”

--Technical Analysis of Stocks and Commodities

[HEAD]

Straightforward option strategies that reduce your risk and increase your profit potential in virtually any investing or trading program

Options for the Stock Investor, Second Edition introduces you to the many ways you can use options to generate guaranteed cash flow, lower the cost basis of your stocks, increase your trading leverage and profit potential, and more.

Updated from its bestselling first edition to provide you with new option techniques and strategies, this comprehensive handbook explores:

• Risk-reduction strategies for conservative investors, including buying calls and covered writing
• Profit-generating strategies for aggressive traders, including vertical spreads, straddles, and strangles
• Flexible strategies for improving your risk/return profile, including covered straddles, covered combos and ratio spreads

Options for the Stock Investor, Second Edition details how investors can use options to effectively control the risk of holding stock positions, and outlines aggressive strategies traders can use to improve their leverage and profit potential.

[FLAP COPY]

Over the past decade, the best selling Options for the Stock Investor has shown thousands of stock investors how to use options to protect their portfolios from bad earnings reports, management miscues, and other unexpected events. Over that same period, scores of new trading rules and products have made options more viable and valuable for trades as well as investors.

Options for the Stock Investor, Second Edition, is updated and expanded to detail the many ways in which options can help you improve your investing performance over both the short- and long-term. Featuring a number of new strategies you can use to enhance your investment performance, whatever your investment style, this hands-on guide provides you with:

• Step-by-step explanations of what options are and how they work
• Detailed examples of option behavior in a wide variety of market environments
• Diagrams to help you visualize the profit or loss potential of every trade before you place it
• Insights into the psychological differences between investing and trading
• Examples of ratio spreads, and how they can be used as a “stock repair” for long positions or as a riskier, more high-profit, strategy for advanced traders
• Strategies for using options to improve the performance of exchange-traded funds, stock indexes, LEAPS, and other popular investment vehicles
---- ----- -----[BOX]

Op-Eval4™ software, provided free with Options for the Stock Investor, allows you to apply option-pricing formulas to options on individual stocks and indexes, and options that are subject to both American-style and European-Style exercise. The features and capabilities of this program increase the transparency of each option trade you make, allowing you to analyze option prices, calculate theoretical option values, graph numerous option only and option/stock strategies, and more.

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An all-stock strategy has become far too uncertain for investors looking to improve stock market returns while protecting those returns, especially with the numerous risk-controlling tools that are available to those investors.

Options are the most versatile and valuable of those tools. Options for the Stock investor, 2nd Edition, shows you how to master the mechanics of options, develop realistic expectations of options behavior in virtually every type of market, and incorporate the protection and profit potential of options into your overall trading and investing program.

James Bittman is senior staff instructor at The Options Institute, the educational arm of the Chicago Board Options Exchange. He has been a successful options trader for more than two decades, and is the author of Trading Index Options, and Trading and Hedging with Agricultural Futures and Options and co-author of Options: Essential Concepts.

Excerpt. © Reprinted by permission. All rights reserved.

OPTIONS FOR THE STOCK INVESTOR

How to Use Options to Enhance and Protect Returns

By James B. Bittman

The McGraw-Hill Companies, Inc.

Copyright © 2005 James B. Bittman
All rights reserved.

ISBN: 978-0-07-144304-3

Contents

Foreword by William J. Brodsky
Acknowledgments
Introduction
Part 1 – The Fundamentals of Options
Chapter 1 – The Vocabulary of Options
Chapter 2 – How Options Work
Chapter 3 – Why Options Have Value
Chapter 4 – Option Price Behavior
Part 2 – Basic Investing Strategies
Chapter 5 – Buying Calls–;An Investor's Approach
Chapter 6 – Covered Writing
Chapter 7 – Adjusted Covered Writes
Chapter 8 – Married Puts, Protective Puts, and Collars
Chapter 9 – Writing Puts
Chapter 10 – LEAPS Have Many Applications
Part 3 – Trading Strategies 159
Chapter 11 – Operating the Op-Eval4 Software
Chapter 12 – Trading Options
Chapter 13 – Vertical Spreads
Chapter 14 – Straddles and Strangles
Part 4 – Advanced Topics
Chapter 15 – Ratio Spreads for Investors and Traders
Chapter 16 – Covered Combos–;Long and Short
Chapter 17 – Cash-Settled Index Options and ETF Options
Part 5 – Investing and Trading Psychology
Chapter 18 – The Difference between Investing and Trading with Options
Chapter 19 – Getting Started
Chapter 20 – Learning to Trade

Excerpt

CHAPTER 1

THE VOCABULARY OF OPTIONS

INTRODUCTION

THIS CHAPTER DEFINES ALL OF THE GENERALLY ACCEPTED TERMINOLOGY THAT AN INVESTORNEEDS TO KNOW. Experienced option traders may notice, however, that not everyterm associated with options is listed. Options are often considered to be farmore complicated than they actually are, a situation that is exacerbated byindustry jargon, which is frequently used incorrectly or with conflictingmeanings. This book will use all essential terms as defined in this chapter:

Call option Assignment (and assignment notice)
Put option American-style exercise
Long call European-style exercise
Short call Effective purchase price
Long put Effective selling price
Short put Option buyer
Long Option writer (or option seller)
Short Covered
Strike price (or exercise price) Uncovered (or naked)
Expiration date In-the-money, at-the-money, out-of-
Exercise the-money
Premium Margin account
Intrinsic value Marginable transaction
Time value Initial margin
Cash account Maintenance margin
Cash transaction Margin call

If you are familiar with these terms, you may proceed to Chapter 2. If you wishto review their definitions, please keep in mind that these definitions arewritten on a basic level. The nuances will be explained in later chapters.

This chapter will look first at call options, then at put options. At the end ofthe chapter, there are questions (with answers following) that are designed toreinforce your understanding.

CALL OPTIONS

A call option is a contract between the call owner (or buyer) and the callwriter (or seller). A call option gives its owner the right to buy stock fromthe call writer at a specified price until a specified date. An equity optioncontract covers 100 shares of stock (one round lot). The strike price (orexercise price) is the price specified in the option contract at which stock istraded if the call is exercised. The expiration date is the date specified inthe option contract, after which the right contained in the option ceases toexist.

RIGHTS AND OBLIGATIONS

The buyer of one XYZ September 50 call has the right to purchase 100 shares ofXYZ stock from the call writer at $50 per share (the strike price) at any timeuntil the September expiration date. The call writer, in contrast, has anobligation to deliver 100 shares at $50 per share. If the call owner exercisesthe right to buy, the call writer must deliver the stock. The call buyer isdescribed as having a long call position. The call writer is described as havinga short call position.

Exercise occurs when the call owner declares the right to buy stock from thecall seller and makes the proper notifications. An assignment notice is given toa call writer and represents notification that a call owner has exercised theright to buy. The process by which this occurs is as follows: When a call ownerdecides to exercise, the first step is for the call owner to notify hisbrokerage firm. The brokerage firm then notifies the Options ClearingCorporation, which is the central clearinghouse and guarantor of all optiontransactions. The Options Clearing Corporation then makes a random selection ofa brokerage firm with a short call position. That brokerage firm, in turn,selects a customer with a short call position and notifies that customer thatthe option has been assigned. Brokerage firms typically select customers oneither a random or a first-in, first-out basis.

At this point, when an exercise form has been processed and an assignment noticehas been sent, a stock transaction has occurred: The call owner is the buyer ofstock, and the call writer is the seller of stock. The price of this transactionis the strike price of the option (plus or minus commissions). On the settlementdate of the stock transaction, the brokerage firms will transfer the appropriatefunds to the seller and shares of stock to the buyer.

A call option ceases to exist after one of two events occurs. First, if the callowner exercises the right to purchase stock, then the call writer must fulfillthe terms of the contract. After exercise, the option no longer exists, butstock has been purchased, and the call exerciser pays the amount indicated bythe strike price. If a 50 call is exercised, for example, the exerciser must pay$50 per share, or $5,000 for 100 shares. Second, if a call is not exercisedprior to expiration, it expires and the right ceases to exist. In this case, theoption is said to expire worthless.

COVERED AND UNCOVERED (OR NAKED) CALLS

If a call writer owns the stock on which the call is written and can deliverthat stock, the short call position is described as covered. In contrast, when acall writer does not own the stock, the short call position is described asuncovered or naked. In the case of an uncovered call, receiving an assignmentnotice means that the investor must acquire the stock to deliver. Since theprice at which the stock can be acquired (or even whether it can be acquired)cannot be known, the uncovered, or naked, call writer is taking a risk that issignificantly greater than the risk taken by the covered call writer.

INVESTMENT POSITION AFTER EXERCISE AND ASSIGNMENT OF CALLS

Both the call owner and the call writer will have different investment positionsafter a call is exercised. Figure 1–1 summarizes the changes. For the callowner with no stock position, the exercised long call becomes a long stockposition (100 shares per option). This is described in Figure 1–1a. If thecall owner had a short stock position on a share-for-share basis with the longcalls, then the call exercise initiates a stock purchase that offsets the shortstock position and leaves the investor flat, i.e., with no position (Figure1–1b). For the call writer, assignment of an uncovered call creates ashort stock position (Figure 1–1c). Assignment of a covered call, however,becomes a flat position, because the stock that was owned is sold (Figure1–1d).

CALLS: EFFECTIVE PURCHASE PRICE AND EFFECTIVE SELLING PRICE

The price at which the call was bought and sold is significant, because it is animportant factor in the ultimate price of the stock transaction. The effectivepurchase price for an exercised call is the price of purchasing stock, takinginto account the cost of the call. The effective selling price of an assignedcall is the price of selling stock, taking into account the proceeds fromselling the call. The following example illustrates this point.

If a 50 call that was purchased for $300, or $3 per share, is exercised, theeffective purchase price of that stock is $53 per share. This price iscalculated by adding the call price to the strike price on a per-share basis.For the assigned call writer, the effective selling price of the stock is also$53: $3 per share is received for selling the call, and $50 is received whenassignment occurs. The general formula–;strike price plus callpremium–;applies equally to the call buyer as the effective purchase priceand to the call writer as the effective selling price.

EXERCISE STYLE

American-style exercise means that the right granted by the option may beexercised at any time prior to the expiration date. European-style exercisemeans that the right may be exercised only on the last trading day before theestablished deadline. In the United States, all equity options and all optionson exchange-traded funds (ETFs) are subject to American-style exercise. Thepopular OEX index options (options on the S&P 100 Index) are also subject toAmerican-style exercise. Most other index options, however, including SPX indexoptions (options based on the S&P 500 Index) and DJX index options (optionsbased on the Dow Jones Industrial Average), are subject to European-styleexercise. All option contract specifications, including exercise style, can beobtained from the exchange on which the options are traded.

CALLS: IN-THE-MONEY, AT-THE-MONEY, OUT-OF-THE-MONEY

The relationship of the stock price to the strike price determines whether anoption is in-the-money, at-the-money, or out-of-the-money. An in-the-money callhas a strike price below the current stock price. If a stock is trading at $55,for example, the 50 call is in-the-money. To be precise, it is $5 in-the-money.This call, however, would not necessarily be trading for $5. In fact, it is verylikely to be trading for more than $5. Why options trade for more than the in-the-money amount is discussed in Chapter 3.

An out-of-the-money call has a strike price above the current stock price. Forexample, if the stock is trading at $55, the 60 call option is out-of-the-money.Specifically, this call is out-of-the-money by $5.

At-the-money means that the stock price is equal to the strike price. This termhas both a strict definition and a looser, common usage. Theoretically, the 55call is at-the-money only when the underlying stock is trading exactly at $55.The rest of the time, it is either in-the-money or out-of-the-money. Inpractice, however, the 55 call is designated as an at-the-money call when thestock price is closer to that strike price than to another strike price. When astock is trading at $54 or $56, for example, it is common practice to refer tothe 55 call as the at-the-money call. Figure 1–2 illustrates therelationship of the stock price to in-, at-, and out-of-the-money calls.

In-the-money, at-the-money, and out-of-the-money are dynamic terms. As stockprices rise, out-of-the-money calls become at-the-money and then in-the-money.As stock prices fall, the opposite happens: In-the-money calls become at-the-money and subsequently out-of-the-money.

CALLS: PREMIUM, INTRINSIC VALUE, AND TIME VALUE

The term premium refers to the price of an option. This premium, or price,consists of two parts: intrinsic value and time value. The intrinsic valuerefers to the in-the-money amount of an option's price, and the time valuerefers to any portion of an option's price that exceeds the intrinsic value.Consider a situation in which the following prices exist:

(per share)
Stock $57.00
50 call 8.00
55 call 4.00
60 call 1.50

An analysis of each option's premium (or price) will illustrate the concepts ofintrinsic value and time value. First, examine the 50 call. The stock price of$57 is $7 above the strike price. Therefore, the 50 call is $7 in-the-money andhas $7 of intrinsic value. The premium (or price) of the 50 call, however, is$8. The $1 difference is the time value.

The $4 premium of the 55 call consists of $2 of intrinsic value and $2 of timevalue. The premium of the out-of-the-money 60 call, $1.50, consists entirely oftime value. Figure 1–3 illustrates intrinsic value and time value for in-,at-, and out-of-the-money calls.

Competition in the market makes it extremely unlikely that in-the-money optionswill trade for less than their intrinsic value. Assume, for example, a stockprice of $56. If the 50 call were trading for $5, investors could buy the call,exercise it immediately, and sell the stock for $56. Since the effectivepurchase price of the stock is $55, the result would be an immediate profit of$1 per share (not counting transaction costs). A profit opportunity of thisnature would attract many professional traders. Competition between professionaltraders would force the call price up and/or the stock price down, reducing the$1 profit per share to an amount only slightly greater than the transactioncosts. For professional traders, transaction costs are very small, and, for thisreason, options in U.S. markets rarely trade below their intrinsic value. Whenthey do, they are very near their expiration date and the amount below intrinsicvalue is only 5 or 10 cents.

MARGIN ACCOUNTS AND RELATED TERMS

Many conservative investors believe that a margin account involves excessiverisk. This is not necessarily true. The level of risk depends on the amount ofmargin debt, if any, and the volatility or "riskiness" of the securitiesinvolved. As later chapters explain, the level of risk of a particular strategydepends on the amount of equity capital supporting that strategy. Paying forstock in cash has the lowest level of risk, because the maximum potential lossis known and is fully paid for up front. If the stock price were to suffer atotal collapse to zero, the investor would not be called upon for additionalfunds. In contrast, buying stock "on margin" involves the use of borrowed money,which must be repaid in full. If a stock price declines to below the loanamount, the investor will be called upon to make up the difference. Thispotential liability is why margin accounts have a reputation for risk.

Investors and traders who use options need to be aware of margin accountprocedures, because some option strategies are required to be established inmargin accounts. The following overview of margin accounts and related terms ispresented for newcomers to these topics.

CASH ACCOUNTS, MARGIN ACCOUNTS, AND MARGINABLE TRANSACTIONS

A cash account is an account at a brokerage firm in which all purchases arefully paid for in cash or in which sufficient cash is on deposit to meet allpotential liabilities. In a margin account, a brokerage firm may allow certaintypes of positions, which are called marginable transactions, when there is notsufficient cash to meet all potential liabilities. Different types of marginabletransactions, according to regulations, require different amounts of equitycapital from the customer. This equity capital is called a margin deposit, orsimply margin.

One common margin transaction is the purchase of stock "on margin." When stockis purchased on margin, there is insufficient cash in the account to purchasethe stock. It is also possible that the equity balance of the account will beless than the value of the stock. If the brokerage firm approves the purchase ofstock on margin, then the firm will lend the balance of the purchase price. Thisis known as a margin loan. The investor, of course, pays interest on the loan.The use of a margin loan means that market fluctuations will change the equitybalance of the account at a greater percentage rate than the same fluctuationwould create in the equity balance of a cash account. This is called leverage.

Another common marginable transaction is selling stock short. In thistransaction, the brokerage firm borrows stock on behalf of the customer, whosells it at the current market price with the hope of buying it back later at alower price. In a short stock transaction, the customer actually pays nothingwhen initiating the position (except commissions), but a margin deposit isrequired to guarantee that the customer will be able to cover any losses.

Certain option transactions are marginable transactions, and certain ones arenot. Also, certain option transactions are required to be conducted in a marginaccount, and others may be conducted in either a cash account or a marginaccount. Before engaging in option transactions, an investor should bethoroughly familiar with the type of account required for the transactions thatare planned. A simple formula to remember is: account equity + margin debt =account value. Account value is the total market value of owned securities.Margin debt is the loan to the investor from the brokerage firm, and accountequity is the investor's share after the securities are sold and the margin loanis repaid.

INITIAL MARGIN, MAINTENANCE MARGIN, AND MARGIN CALLS

Initial margin is the minimum account equity required to establish a margin-abletransaction. Initial margin requirements are frequently expressed as apercentage of the market value of a position or its underlying security.Purchasing stock, for example, is a marginable transaction that currently has aninitial margin of 50 percent: The purchase of 100 shares of a $50 stock requiresan initial margin of 50 percent of the purchase price plus commissions, or$2,500 plus commissions, and the loan made to the buyer would equal $2,500.

If a margined position loses money, the account equity will decrease, bothabsolutely and as a percentage of the total account value. Minimum margin is thelevel, expressed as a percentage of account value, above which account equitymust be maintained. If account equity falls below the minimum margin level, thebrokerage firm will notify the investor through a margin call that the accountequity must be raised to the maintenance level. Upon receiving a margin call, acustomer may either deposit additional funds or securities or close theposition. In the previous example, a stock price decline from $50 to $35 wouldcause a decline in equity to $1,000, because the margin loan of $2,500 remainsconstant. This $1,000 equity would represent only 28 percent of the accountvalue ($1,000 ÷ $3,500 = 0.28). If the minimum margin were 35 percent, theaccount equity would be under the requirement, and the customer would receive amargin call.

(Continues...)

Excerpted from OPTIONS FOR THE STOCK INVESTOR by James B. Bittman. Copyright © 2005 by James B. Bittman. Excerpted by permission of The McGraw-Hill Companies, Inc..
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.

Edition details

• Publisher: McGraw Hill
• Publication date: 2005
• Language: English
• ISBN 10: 0071443045
• ISBN 13: 9780071443043
• Binding: Paperback
• Edition number: 2
• Number of pages: 256